Friday, June 29, 2012

Does Australia have a housing affordability problem?

There are a few key words that get thrown around time and time again when it comes to property in Australia. 

Take "shortage" for example. Someone bearish on Australian property as a whole might argue that with 10% of Australian homes empty (according to the latest Census statistics) we don't have a shortage of property in Australia (this level of empty homes has been relatively consistent for the last several decades). Another person who invests specifically in some Perth or Sydney suburbs where prices are rising sharply might argue that a shortage of homes in this specific area is driving rents and/or prices higher. Both of these individuals might be right (in the context of their own views), but they will probably squabble with each other for hours if you lock them both in the same room and tell them to discuss whether or not we have a shortage of property in Australia.

Another one of these key words is "affordability". It has been a very hot key word as prices rocketed to their peak on a national scale in early 2010 (using the RP Data/Rismark indices) and have slowly deflated since.

Some would go to the dictionary and grab the first definition of the word and throw that into the face of the property detractors who say Australian property isn't affordable:

"Afford: To have the financial means for; bear the cost of."

The "affordability problem" deniers will say things like "If Gen Y stopped spending all their money on iPods, LCD televisions, laptops, overseas holidays and widgets, then they would be able to afford a property" (and sadly this is almost a direct quote of the sort of rhetoric I see get thrown around). 

The "affordability problem" deniers will argue that younger generations are expecting too much for their first home. They will argue that living 40km out from the CBD is a reasonable expectation for First Home Buyers, when outer suburbs at the time they purchased meant 8km out from the CBD instead of 5km. They will argue that First Home Buyers should just buy whatever they can (even if it's a run down 2 bedroom hovel which the buyers will grow out of in a few years) to use it as a stepping stone in order to build equity and buy a larger home later down the track. 

The "affordability problem" deniers will argue black and blue that if a buyer can live off two minute noodles, take a cash handout from the government, leverage their savings (and handout) 20:1 (95% LVR) in an environment where interest rates are near historical lows, to buy the worst house on the worst street in the worst suburb of the city they live in then property is still affordable.

Personally I would use this definition for affordability of housing:

"Afford: To manage or bear without disadvantage or risk to oneself."

Both of the above definitions were from the same dictionary, yet both put a fairly different spin on what affordability means in the context of buying a home.

The first definition suggests that if it is financially possible then it is affordable, the second if you can manage it without putting yourself at risk then it's affordable.

Affordability of Australian property cannot be calculated on a mathematical equation alone. 

Some historical measures of affordability have attempted to formulate an affordability measurement based on the percentage of your income which is taken by housing costs. Typically 30% has been a level to gauge affordability (e.g. if you're having to spend more than 30% of your income on housing then it's not affordable), but the problem with this is spending 30%+ on housing could have a much larger detrimental effect on someone with a low income.

Another issue I see with this type of measurement is that the calculations today are being made in an environment where interest rates are near historical lows and pose a pretty big risk if/when they start to increase again.

Take a mortgage holder in the mid 1990s for example who may have had a mortgage rate of 12%. A 1% increase in rates for this borrower is an 8.3% increase on interest costs for the loan. With current low rates a 1% move higher where the borrower is on 6% is a 16.6% increase in cost of interest. For a new borrower this will increase the repayment by a significant amount and poses a significant risk, especially where they have borrowed with a high LVR.

One of the arguments made by housing commentators such as Chris Joye is that the low interest rate environment has allowed for appreciation of house prices and that the price rise can be justified almost completely by the fall in interest rates. Take for example this quote from an article he posted on Property Observer yesterday:
There is a sound explanation for this innovation: the long-term cost of mortgage debt in Australia declined by north of 40% between 1980 and 1995, and 1995 and today. This was largely a function of the long-term reduction in realised inflation and measured inflation expectations, which in turn allowed Australia’s central bank, the RBA, to permanently lower its cash rate.
The radical reduction in the day-to-day cost of mortgage debt permitted Australian households to significantly increase the amount of debt they were servicing without a noticeable rise in underlying mortgage default rates.
Although this argument holds water on a serviceability level, if we look at the effects that a doubling price and halving interest rates have on a mortgage holder over the term of their loan it's a real eye opener (use this mortgage calculator to run your own scenario):

$300,000 borrowed @ 6%
Repayments of $2000 per month
23 years, 2 months to payoff loan
Total repayments = $555,903

$150,000 borrowed @ 12%
Repayments of $2000 per month
11 years, 7 months to payoff
Total repayments = $278,643

The initial interest costs on a $300k loan at 6% is the same as a $150k loan at 12%, however the smaller loan is repaid at a much faster rate if the borrower has the capacity to repay either loan at the same rate.

So are lower interest rates making property more affordable? Not if prices rise to fill the serviceability gap.

By taking on a larger amount of debt, even if the interest rate is half of some historical levels, borrowers are taking on significantly larger amounts of risk and hence by the second definition perhaps can't be considered as affordable as some would make them out to be.

Many bullish housing commentators have been talking about falling interest rates bringing back buyers to the market, but I think that buyers are starting to smarten up on the whole "lower interest rates makes property affordable" lie. Even following two cuts in late 2011 and two more this year (including a 50 point cut in May) we have buyers sitting on the sidelines waiting for lower prices. As Leith points out on MacroBusiness today:

What is most worrying about this result is that it follows the RBA’s -0.5% cut in official interest rates in early-May. While it is only one-month’s data, these figures imply that this rate cut had absolutely no impact on mortgage demand which, in fact, took another leg down over the month.
Housing credit growth continues to remain at very subdued levels, which ties in with the very low volumes of sale (from RP Data):

It seems that even if buyers could continue to buy prices at current levels, they are choosing not to afford property (given the risks). A wise choice in my opinion as the short term downside is a much greater risk than missing out on upside.

In my opinion the best thing that Government could do to help any perceived affordability problem is to step back and stop meddling with the markets, let them deflate.

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  1. Like Einstein said:
    “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."

    1. Great quote, don't recall hearing it before.

    2. More money has been lost chasing yield in history than at the point of a gun

  2. The whole thing has been pumped up via bank debt, investors (that have squeezed out families fueled by the idiot tax system), dubious lending practices, restricted land release, etc.

    It is a massively bubble that may unwind slowly but my bet is that at some point it will become a crisis. There are nearly a million unoccupied properties across Australia and prices fall some more investors will panic and divest.

    Another point is that I live in a fairly affluent part of Sydney and two things can be observed - local retailers are going out of business (not just a few but lots of them) and the number of commercial/office property vacancies is growing rapidly.

    The GDP growth rates and claims of sound economic growth are rubbish. The whole economy is being propped up by mining and when that slows, as it will, then there will be issues.

    1. Agree with everything you say, but I think it can be difficult to use this knowledge to time investments.

      We may very well be on a precipice here in Australia, but another kick of the can globally by central banks and locally (lowered rates and handouts) could pull us back from the edge again for a couple more years.

  3. Greetings, BB. The ratio of vendors to purchasers is critical in the housing market. You may be old enough to recall that surge in Australia in the housing market in the early 1970's. It is not mere coincidence that those 'baby boomers' aged into the first home buyer demographic. The late house price bubble began to pump up as the 'baby boomers' aged into the age bracket which typically builds or buys the largest home a couple or individual ever buys and their children, the so-called 'echo boomers' aged into the first home buyer age bracket. The next housing move by those boomers is a 'downsizing. Note also that the numbers of young Australians ageing into the first home buyer market over the next decade or so remains almost flat. The housing market is sliding down a steepening slope. A crash now is almost inevitable. "The shrewd money always moves first" It has moved as shown by bank term deposit rates.

    1. I'm under 30, so no memory of the 70's ;)

      I think there is definitely the potential for a crash, but perhaps we need an event or tipping point to drive the sell off, because as it stands now sellers and buyers are in a stand off, no one prepared to budge (buyers not paying high asking prices, sellers not accepting low balls). I don't think downsizing boomers is enough to cause a crash, think it would take a spike in unemployment...

  4. interest rates only have to go up to 8% on that 300k loan and the 2000 a month payments will never pay off the principle, it will only cover the =24 k annual interest bill. debt slide!